May 2024 Letter

Although parts of this letter are another seemingly sobering message from me, the overal lmessage remains highly relevant to current and future economic developments.  Within these developments lie unprecedented opportunities for growth and innovation, paving the way for a brighter economic future.

To kick things off, in Summer 2022 I wrote a blog titled What Is An Inverted Yield Curve And What Does It Mean?  After two years, the yield curve is still inverted and, if you look at history, just about every time the yield curve has been inverted for a year, a recession has occurred.  Why has this time been different?

Before getting to that important question, we should probably recap why a yield curve inverts and why it’s a phenomenon that indicates a recession is ahead.  Additionally, even as a finance and accounting professional, my understanding of the yield curve has evolved over the past two years.  To summarize, a yield curve inversion means that the interest rate (“yield”) on a long-dated treasury bond (10-30 years) is lower than that of a short-dated treasury (3 months-2 years).  If you then plot the curve of all bond yields across 30 years, you find this inversion image.  This is abnormal in comparison to a normal shaped yield curve where longer dated bonds have a higher yield.  Locking up your assets in a longer-dated bond normally demands a higher yield to account for:

1.     Credit Risk – The longer the duration of the bond, the greater the uncertainty regarding the issuer's ability to repay.

2.     Liquidity Risk – Longer-term bonds may be less liquid than shorter-term bonds.  Investors may find it harder to sell quickly without affecting its price, thus requiring a higher return for this reduced liquidity.

3.     Opportunity Cost – Locking in could cause you to miss other investment opportunities.

4.     Interest Rate Risk – Longer-term bonds are more sensitive to negative price fluctuations if interest rates rise.

5.     Inflation Risk – Over a longer period, the purchasing power of the money returned to the investor at maturity can be eroded by inflation.  Investors demand higher yields to compensate for this potential loss in purchasing power.

So, why would the market turn all this logic on its head by pricing a lower interest rate on longer-dated bonds?  Even harder to understand, why would an inverted yield curve indicate or lead to a recession?  

Here’s how I find it easiest to understand: the short end of the yield curve (i.e., short-term bonds) is significantly influenced by the Federal Reserve.  For instance, if the Federal Reserve raises the Fed Funds rate to 5%, you can expect short-term interest rates to hover around that 5% mark.  However, the long-end of the yield curve is a different story.

When the Federal Reserve raises rates, borrowing becomes more difficult for individuals and businesses.  This reduced borrowing leads to less spending, which in turn slows down the economy with decreased hiring and spending.  This is where it gets interesting and somewhat abstract.  The long end of the yield curve (10-30 years) is not as directly affected by the current rates.  Instead, it reflects the market’s expectations for future growth and inflation.  In other words, if the Federal Reserve maintains tight monetary policy, the market anticipates that this will eventually dampen economic growth.  In such a scenario, bonds are seen as safer than stocks, leading to a flight to safety.  Said a different way, when investors expect slower economic growth they expect central banks to lower short-term interest rates to stimulate. Anticipating lower short-term rates in the future, investors buy long-term bonds to lock in current yields which drives up the price of these bonds and lowers their yield.  

I know it’s confusing, but I hope you will keep reading.  You only need to know that long-term interest rates are driven by expectations.  This process takes time to permeate the economy, eventually leading us (with a lag) to a period of economic weakness.

Why Are Interest Rates Higher Now, But the Economy Has Not Slowed Down?

It's crucial to remember that correlation does not imply causation. In my explanation of the inverted yield curve, I outlined how a monetary-tightening-induced credit crunch could lead to a recession. However, this outcome is not inevitable. There are several reasons why the current inverted yield curve has not yet resulted in a recession.

1.     Locked-In Low Interest Rates

The private sector was very smart to refinance with extremely low rates (e.g., 3% 30-year mortgages).  For many individuals in this country, there is no need to sell the house or refinance unless there’s a significant life event (e.g., job loss).  At the corporate level, they engaged in similar activity by issuing long-dated bonds at the low prevailing market rates of the time.  In other words, these recent higher rates are taking a longer time to push through the economy because of the wise, lock-in decisions borrowers made with the extreme low rates of the last decade.  The time to refinance has largely not yet kicked in.

2.     Fiscal Deficits

Federal spending and debt have been used to drive growth.  As of fiscal year2023, the U.S.  federal budget deficit is approximately $2 trillion, or 6.3% of Gross Domestic Product (“GDP”);  GDP also grew by approximately $2 trillion dollars in 2023.  This tells us that the extra infusion into the economy is what prevented a year of no growth (or perhaps a recession).  Jaime Dimon, CEO of JPMorgan, and billionaire hedge fund manager Ray Dalio recently discussed the soaring government debt.  The more the government spends, the better GDP artificially looks.  Government spending and borrowing is propping up what would likely be a flat economy and keeping the normal cyclical recession from happening.

The level of borrowing is admittedly concerning.  Borrowing is essentially pulling forward future earnings. It artificially makes an individual, business, or country feel richer today, but slows growth in the future.  This occurs because the resources used to service debt, such as interest payments, reduce the funds available for productive investments (i.e., actual growth).  Over time, high levels of debt can lead to increased taxes and reduced government spending on essential services and infrastructure, which can further hamper economic growth—it becomes quite the domino effect.

3.     Higher Interest Rates Becoming Stimulatory?

While rising interest rates can often be seen as a headwind for economic growth, it's important to recognize that they can also have stimulatory effects on certain segments of the economy.

Holders of bonds and money market accounts benefit from higher yields on their savings. This increase in income can translate into greater spending power, enabling these individuals to invest more in goods and services. This boost in consumption can stimulate sectors of the economy that cater to these higher expenditures.

However, it's worth noting that this form of stimulus tends to be somewhat regressive. The primary beneficiaries are those who already have significant savings and investments, which typically includes more affluent individuals. As a result, the economic boost from higher interest rates is not evenly distributed across all income levels, but rather concentrated among wealthier households.

4.     The Fed's Expertise in Managing Rate Hikes

The Federal Reserve has honed its ability to manage interest rate hikes over its 100 years of experience. As previously stated, the most common reason for recessions has been the tightening of monetary policy as the Fed aimed to control consumer price inflation. However, the recent round of tightening has not followed this pattern. Last year in March, a mini-banking crisis emerged, affecting three banks. The Fed responded swiftly by establishing the Bank Term Funding Program (“BTFP”), an emergency banking facility designed to contain the crisis quickly. This rapid intervention prevented the crisis from escalating into a full-blown credit crunch and subsequent recession.

The Fed's ability to set up and manage such facilities has improved significantly through its experiences during the Great Financial Crisis (“GFC”) and the Great Virus Crisis (“GVC”).

Are We Not Allowed to Have a Recession Anymore?                              

First, please see this chart.  

Policy makers of late have worked hard to limit the time we are in a recession.  To dig even deeper, over the last two decades the amount of time the US has spent in recession is the lowest ever.  On the surface, this seems like a great achievement for a policymaker: minimal recessions!  Nevertheless, there are downsides for these policy decisions, such as:

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(1) Recessions can have a cleansing effect on the economy

(2) Did the medicine really cure the ailment?

In regards to #1, of course nobody likes recessions, and we want them to be short when they do happen. But recessions are nonetheless an economic cleansing of unproductive companies or areas of the economy.  For example, the GFC forced General Motors to streamline and discontinue some of their less profitable lines, such as Saturn and Pontiac. It’s been 15 years since then, and it the last true, organic recession.  Recessions used to happen every 7-8 years.  Now it seems policymakers will do whatever they can to avoid a recession on their watch. The worry here is that artificial stability could lead to greater future instability.

In regards to #2, only time will tell.  In the past, policymakers have viewed expansive fiscal policy (“stimulus”) and government borrowing more rationally.  If the economy was humming along with moderate growth and low unemployment, policymakers would not typically advise running a deficit.  On the other hand, if the cycle weakened, then policymakers would borrow and stimulate.  However, since 2008, we have seen uninterrupted stimulus through either fiscal policy (borrowing and spending from the federal government) and/or monetary policy (low interest rates or quantitative easing from the central bank).

During my college years and early career amidst the GFC, I witnessed a significant shift in economic dynamics.  As a finance student, we would model various negative data points, such as a slowdown in an economic sector or a rise in credit card defaults. These indicators typically foretold what one would expect in a free market:

1. The economy is weakening.

2.Growth and inflation are slowing down.

3.Equities are likely to perform negatively.

I recall an exercise where we charted negative economic data against the S&P 500 returns; the correlation was almost perfect—negative data led to market dips shortly after. However, since the GFC, this relationship has largely inverted.  Today, when data turns negative, instead of expecting a declining equity market, we often see the opposite.  Markets now anticipate monetary stimulus from the Federal Reserve or fiscal stimulus from the Federal Government in response to bad economic data.  Markets now price in a new era of central bank and fiscal stimulus, where bad economic signs are interpreted as positive signals for the equities markets because it signals intervention from the Fed.

Simon Johnson, a former chief economist at the IMF, referred to our policy decisions since the GFC as "The Quiet Coup." Though the article is now behind a paywall, his main point was that U.S. policymakers addressed the GFC not as a free-market capitalist economy would, but rather in a manner similar to an emerging market oligarchy. The article serves as a cautionary tale, warning that such approaches can eventually lead to dysfunction and the kind of volatile inflation often seen in many emerging markets.

What Next?

As I have written to many of you previously, my primary economic concern for the next decade is the potential for inflation volatility. We may experience periods of high inflation and even some instances of deflation. This marks a significant change from the past few decades, where CPI inflation has remained low and steady. While such volatility is not a certainty, it becomes a plausible scenario when government debts exceed manageable levels.

With the dollar being the reserve currency of the world, the U.S. has had a lot of slack in the rope since choosing a new path after the GFC.  There is a lot less slack in the rope 15 years in and the national debt $20 trillion larger than it was at the start.

Why is inflation the likely solution? The answer is that the most rational approach to a soaring debt problem is to monetize the debt.  In other words, the central bank prints the money and buys the debt.  This is classically inflationary, although Japan would like a word on that (perhaps for another day).  Inflation beats the alternative of drastically cutting entitlements or defense spending. Fortunately for us, the debt is owed in dollars, and we are the only country that can print dollars t ohelp address the debt.

If sustained inflation occurs, wages for working people will adjust accordingly.  Those most affected will be the wealthiest in society with a majority bond portfolio.  Unfortunately, some non-affluent retirees have built their entire retirement income on an all-bond portfolio or a fixed annuity.  I fear they will experience negative real, inflation-adjusted returns. Real financial wealth comes from owning great companies and real assets.  For the time being, I believe bonds should be viewed as a short- and medium-term cash-flowing tool until the inflation threat is resolved.

The most important thing to note is that everything is going to be okay.  While the financial landscape may shift and present challenges, history has shown that economies and markets are resilient.  By staying informed, making prudent investment choices, and remaining adaptable, we can navigate these changes successfully.  Remember, the key to financial stability and growth lies in diversification and a long-term perspective.

I strive to write in an accessible way for those without a background in economics, finance, or accounting, but I understand that these concepts can become confusing quickly.  Apart from about 10 days next month when my wife and I expect to welcome our daughter into the world, I am always available to you.  Whether you want to discuss economics, your portfolio construction, or even your opinion on breastmilk vs. formula, I am here for you.  I sincerely thank you for your trust and for allowing me to guide you through these important concepts.

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